Nominal Vs Real Exchange Rate
Nominal and real exchange rates are the main types of exchange rates that are used in the foreign exchange market and international trade. The nominal exchange rate defines the value of a given currency that can be traded for a single unit of another. On the other hand, the real exchange rate outlines the amount of goods or services in a given country that can be exchanged for a single unit of that good or service in a different country. For instance, a real exchange rate can be the number of US bottles of wine that can be traded for a single bottle of Russian wine.
When you are making comparisons between real and nominal exchange rates, it is important to take note that the former can be a little complicated than the later. This is because the real exchange rate is specifically based on goods and services while nominal exchange rate bases its arguments on the value of currency. The real exchange rate is obtained by multiplying nominal exchange rate to the domestic price.
The real exchange rate and nominal exchange rate can both be relied upon when trying to establish the cost of living in two countries that are trading partners. When the real exchange rate is higher, there can be a false indication that one unit of domestic currency can be used for purchasing a huge amount of foreign goods. A high nominal exchange rate cannot be used to give such a justification.
A high real exchange rate can significantly increase imports while at the same time, decreasing net exports and vice versa. The reason for this is because, the relative price of commodities in the local markets are pushed higher while those abroad decrease in the event that there is a higher rate of real exchange. Nominal exchange rate does not possess such a characteristic.
A nominal exchange rate is neither influenced by the change in prices nor value of goods and services that can be bought using various currencies. However, changes can only occur over a period of time due to shifts in the value of a given currency. Besides, changes can also result from the associated prices of commodities that the currency can be used in obtaining. The nominal exchange rate is usually set on the open market and depends on the amount of a given currency that can be bought using another.
When seeking to determine the real exchange rate, the final figure that is derived includes the adjustments for the impacts of inflation. These figures will factor in a variety of transaction costs including tariffs and others that are associated with importation of commodities. The real exchange rate is a true reflection of the amount of money that consumers will pay to purchase imported goods. Nominal exchange rate on the other hand, only gives an estimation of the relative prices that will be paid by consumers for imported goods. This means that it is mainly an assumption such that, the prices to be paid for imported goods by consumers may at times be contrary to their expectations.
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